Following well-deserved criticism for clinging too long to ultra-accommodative monetary policy, the Federal Reserve (the Fed), at its December 15 meeting, finally admitted that soaring inflation did not was not a transitory phenomenon and indicated that some degree of tightening will be necessary to restore price stability. Even some dovish Fed officials displayed a welcome pivot in their stance and appeared open to anticipated rate hikes.
The Fed, however, faces multiple challenges as it aims to stage a soft landing for the US economy in 2022. First, an extended period of policy rates close to zero and the extraordinary amount of liquidity the Fed has injected into the financial system. since March 2020 have contributed to speculative fervor and soaring asset prices. The end of the Fed’s asset buying programs and the launch of rate hikes will trigger a much needed valuation reset. The fluidity of the process is, however, to be guessed.
The possibility of a sharp and disruptive change in asset values cannot be ruled out if faster-than-expected monetary tightening is needed to cool the economy sufficiently to ease upward pressure on prices. In addition, at some point, the Fed will be forced to take quantitative tightening measures aimed at reducing its balance sheet by $ 9 trillion.
Such actions will affect the risk-free rate as well as the equity risk premium and the term premium and potentially deflate financial asset bubbles. The Fed must make it clear to market participants that its main mandate is to ensure price stability and the maintenance of full employment, and that it is not obliged to constantly pursue an ultra-accommodative monetary policy to help the markets. financial and keeping Wall Street happy.
In fact, a former Minneapolis Fed chairman recently questioned whether the reason for the central bank’s persistent delay in initiating policy tightening was “to avoid shocking investors, who have become accustomed to it. ‘monetary accommodation – a modern version of the’ Greenspan put, ‘the widely held belief that the Fed would always intervene to keep asset prices from falling too quickly. ”
A second challenge facing the Fed concerns its ability to achieve the terminal rate needed to restore price stability while maintaining stable economic and financial conditions. With explosive growth in US government debt and non-financial corporate debt, the Fed could face a serious debt trap.
Economist Nouriel Roubini recently observed that “with such a massive build-up of private and public debt, markets may not be able to digest higher borrowing costs. In a crisis, central banks would find themselves in the debt trap and likely turn around. This would make inflation expectations likely to change upward as inflation becomes rampant. “
Gross federal debt now exceeds $ 29 trillion, and publicly held debt exceeds $ 22 trillion. At this time, record debt levels are not a threat in the near term, given the extremely low borrowing costs facing the US Treasury. The bond market is signaling that the Fed has limited ability to raise rates. However, even a modest increase in yields will imply a substantial increase in net interest payments to the federal government. Corporate debt has also exploded and threatens the Fed’s ability to fight inflation by raising interest rates sharply.
Meanwhile, various factors suggest that the upward pressure on prices will persist and cause high inflation expectations to be built into the system. For example, rising house prices and surging rents indicate that inflation may be more rigid than the Fed initially assumed. Structural changes and population shifts can drive up house prices and create sustained pressure on rents in a wide range of communities across the United States.
In addition, US shale oil producers have abandoned their “growth at any cost” model and, along with their Big Oil brethren, are demonstrating capital discipline to satisfy investors. Such behavior, however, limits the potential for a short-term increase in domestic oil and gas production that could alleviate supply problems. Rising energy costs and unusual weather conditions are also contributing to sustained food inflation.
Given these developments, high inflation will continue to be a problem for the Fed in 2022. Even from a political perspective, inflation will remain the main problem as the midterm elections approach. Aggressive tightening to ease demand may be warranted to cool the economy and achieve disinflation. But too rapid a cooling of the economy or a disruptive asset market crash can lead to a hard landing for the US economy.
The Fed could still be lucky and achieve a soft landing if inflationary pressures partially abate in the first half of 2022. This could happen if global supply chains recover relatively quickly and demand for goods moderates and is offset by increased demand for services. An increase in labor market participation, especially among workers in their prime, would also help ease upward pressure on prices by limiting wage demands.
But the burgeoning omicron variant is likely to further delay such developments and may even add to existing pricing pressures. Barring unexpected developments, inflation is likely to remain the main economic challenge in 2022. Therefore, the real question is whether the Fed has the necessary leeway and the will to undertake sufficient monetary tightening to control inflation.
Vivekanand Jayakumar is Associate Professor of Economics at the University of Tampa.